What Today’s Stock Drop Says About the Economy

Another day, another loser in the market. At least that’s how it feels. The Dow Jones industrial average dropped 265 points, and now stands at just under 10,400. Yesterday, the Federal Reserve said that it plans to buy more Treasury Bonds in an effort to continue to stimulate the economy. And if the economy needs stimulating then everyone guesses it must still be pretty weak. Surprisingly, in good times, Fed moves like this one can boost the stock market. But these are not good times. So the stock market falls. As Barry Ritholtz says look out below.

But the question is just how bad a times are these. The stock market is usually a pretty good forward indicator of where the economy is headed. So the recent market drops must mean we’re again headed for rough economic times, right? Not necessarily. Here’s why:

The main reason is that the market is not as bad as it seems. The problem like in poker is that we only remember the losing hands, the bad beats, or in investing the days when the market is down. Surprisingly enough we tend to forget the good days. Looking at another down day today, I though for sure we had hit some record on the number of days with market drops this year. Not even close. So far in 2010, the market has been down 200 points or more 11 days, including today. How does that compare to other years?

The market fell 200 points or more 15 times in 2009. So we are on pace to beat that. But we are not even close to the number of down days in 2008. That year the market had 49 days in which the market fell 200 points or more. In fact, this year the number of down days has roughly equaled the number of up days. As for 200 point plus days, we are only slightly in the negative column. The market has been up 200 points or more on 8 days, only three less than the number of days it has been down that much. Overall, the Dow Jones Industrial Average is down less than a percentage for the year.

So what does all this mean? I’m not exactly sure. But what it may mean is that the economy is not as doomed as today’s drop suggests. In part, the Fed’s move is window dressing and investors signaled to the Fed that they know that. The Fed will use federal dollars to buy debt that is being issued by the Treasury. So we are using our dollars to buy our own debt. In theory, it should stimulate the economy by increasing the money supply, but it is a little bit of just reshuffling the deck. And in the end it won’t do nearly as much as if Washington passed a new stimulus bill, or even cut taxes.

The real long-term problem is the growing consensus that the stock market is a no-win game. Megan McArdle has a story in the current Atlantic saying that stock market returns may never return to what we have come to expect of them. Part of what propels stocks is confidence that they will do better than other investments. That’s what created the equity premium in the 1980s and 1990s. And that has slowly slipped away. That’s bad news for the stock market. But it might not say anything about the economy.